Lecture 17 Real Business Cycles Money Noah Williams University of Wisconsin - Madison Economics 702
Simulations from a Quantitative RBC Model We have seen the qualitative behavior of the model, showing that the real business cycle model is consistent with the data. Apart from the special case we studied, to fully solve the model we need to use numerical methods. Calibrate the model: choose parameters to match some key economic data. Example: set β so that steady state real interest rate matches US data. Program up on computer and simulate: use random number generator to draw technology shocks, feed them through the model. Compute correlations and volatilities and compare to US data.
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Assessment of the Basic Real Business Model It accounts for a substantial amount of the observed fluctuations. Accounts for the covariances among a number of variables. Has some problems accounting for hours worked, consumption volatility. Are fluctuations in TFP really productivity fluctuations? Factor utilization rates vary over the business cycle. During recessions, firms reduce the number of shifts. Similarly, firms are reluctant to fire trained workers. Neither is well-measured show up in the Solow residual. There is no direct evidence of technology fluctuations. Is intertemporal labor supply really so elastic? All employment variation in the model is voluntary, driven by intertemporal substitution. Deliberate monetary policy changes appear to have real effects.
Application of the Theory: the Great Depression Great Depression is a unique event in US history. Timing 1929-1933. Major changes in the US Economic policy: New Deal. Can we use the theory to think about it?
Data on the Great Depression Year u Y C I G i π 1929 3.2 203.6 139.6 40.4 22.0 5.9 1930 8.9 183.5 130.4 27.4 24.3 3.6 2.6 1931 16.3 169.5 126.1 16.8 25.4 2.6 10.1 1932 24.1 144.2 114.8 4.7 24.2 2.7 9.3 1933 25.2 141.5 112.8 5.3 23.3 1.7 2.2 1934 22.0 154.3 118.1 9.4 26.6 1.0 7.4 1935 20.3 169.5 125.5 18.0 27.0 0.8 0.9 1936 17.0 193.2 138.4 24.0 31.8 0.8 0.2 1937 14.3 203.2 143.1 29.9 30.8 0.9 4.2 1938 19.1 192.9 140.2 17.0 33.9 0.8 1.3 1939 17.2 209.4 148.2 24.7 35.2 0.6 1.6
Output, Inputs and TFP During the Great Depression Theory Data (1929=100). z z =. Y. Y α K N (1 α) K N Year Y N K z 1930 89.6 92.7 102.5 94.2 1931 80.7 83.7 103.2 91.2 1932 66.9 73.3 101.4 83.4 1933 65.3 73.5 98.4 81.9 TFP fell dramatically, as did output, employment.
105 Figure 1: Real Output, Consumption and Private Hours (Per Adult, Index 1929 =100) 100 95 90 Indices 85 80 Consumption 75 70 65 Output Hours 60 1929 1930 1931 1932 1933 1934 1935 1936 1937 1938 1939 Years
Output and Productivity after the Great Depression Cole and Ohanian (2001). Data (1929=100); data are detrended Year Y z 1934 64.4 92.6 1935 67.9 96.6 1936 74.4 99.9 1937 75.7 100.5 1938 70.2 100.3 1939 73.2 103.1 Fast Recovery of z, slow recovery of output. Why?
New Deal Policies Although New Deal mostly remembered for public works and expansion of government spending, it also introduced regulations in labor and product markets. National Industrial Recovery Act of 1933 allowed explicit cartelization. It permitted industry-wide collusion provided that firms raised wages and agreed to collective bargaining. This led to distortions in both product markets through market collusion, labor markets through controlled wages. Prevented adjustment of prices and wages to new equilibrium. Cole and Ohanian developed a model with these policies, found it could explain 60% of the weak recovery.
Figure 2: Comparing Output in the Models to the Data 110 100 Competitive Model Indices 90 80 70 Cartel Model Data 60 50 1933 1934 1935 1936 1937 1938 1939 1940 Year
Money Two basic questions: 1 Modern economies use money. Why? 2 How/why do changes in the amount of money affect nominal and real variables in the economy? Uses/functions of money: (1) Unit of account: contracts are usually denominated in terms of money. (2) Store of value: money allows consumers to trade current goods for future goods. (3) Medium of exchange: facilitates transactions.
Money in Exchange Non-monetary transactions require barter: one good or service is exchanged directly for another. Requires a double coincidence of wants: each party must want what other has. Other objects, like stocks and bonds, can be store of value and medium of exchange. Can dominate as store of value since they give a positive rate of return. But stocks and bonds are not efficient in exchange: 1 Agents not well-informed about the exact value of stocks. 2 It is not always easy to sell these assets. (Liquidity) Money very efficient in exchange. Facilitates specialization. In absence of regular money, other objects appear as media of exchange (cigarettes in POW camps).
Types of money Ancient Greek coins, ca 700 BC Cowry shells Stone money of the island of Yap
Measuring Money Most modern money is fiat. It is inherently useless. Valuable only because others value it. In contrast, earlier money was commodity money. Explicitly backed by gold or silver. How do we measure the money supply? Distinguishing what to count as money is more difficult because of financial innovation. Different measures depending on how broad. Monetary base (M0): currency and bank reserves
M1 and Its Currency Component
M1: M0 + traveller s checks, demand deposits (non-interest checking), checkable deposits (may earn interest). Closest to our theoretical description of money. M2: M1 + additional assets which less like money. Savings deposits, money market accounts, small time deposits. Most US currency held outside US. In 1999, currency averaged $1800 per person, but average personal is $100. Some held by business, and underground (criminal) economy. But over half of US currency is held outside US. Dollarization of many especially Latin American countries where US $ is unofficial currency for transactions.
M2 and M1
Money Supply Central bank (US: Federal Reserve, European Central Bank, Bank of England, etc.) regulates money supply. Changes in money supply take place through open market operations. The purchase and sale of securities, typically government bonds. Increases money supply by buying financial assets from the public. Exchanges money for assets, putting more money in hands of public. Decreases money supply by selling assets.
Federal Reserve System Open Market Account
Federal Reserve Balance Sheet
Federal Reserve System Open Market Purchases
Real and Nominal Variables Up to now all our models have been real: focusing on determinants of quantities produced. Numeraire was units of consumption goods. In monetary models, money is the natural numeraire. P is the current price level (price of goods in units of money) P is the future price level. The inflation rate π is the growth rate of the price level: π = P P P. A nominal bond costs $1 today, pays $1 + R in the future. A real bond costs 1 good today, pays 1 + r in the future. How are inflation, nominal, and real interest rates related?
History of the Price Level
The Fisher Equation Consider the following sequence of transactions: Take one unit of goods, buy P units of money. Sell P units of money for P nominal bonds. Wait until the future period, getting P(1 + R) units of money. Take P(1 + R) units of money, buy P(1+R) P units of goods. This replicates purchasing a real bond. In the absence of arbitrage: Equivalently: 1 + r = P 1 + R (1 + R) = P 1 + π, r = R π rπ R π r = R π is the Fisher equation.
Inflation and Interest Rates